It may be argued that the host country should not complain about transfer pricing, because, without the foreign direct investment in question, the taxable income would not have been generated in the first place. But this is a disingenuous argument. All firms need to use productive resources provided by government with taxpayers’ money (e.g., roads, the telecommunications network, workers who have received publicly funded education and training). So, if the TNC subsidiary is not paying its ‘fair share’ of tax, it is effectively free-riding on the host country.
Even for the technologies, skills and management know-how that foreign direct investment is supposed to bring with it, the evidence is ambiguous: ‘[d]espite the theoretical presumption that, of the different types of [capital] inflows, FDI has the strongest benefits, it has not proven easy to document these benefits’ – and that’s what an IMF publication is saying.[25] Why is this? It is because different types of FDI have different productive impacts.
When we think of foreign direct investment, most of us think about Intel building a new microchip factory in Costa Rica or Volkswagen laying down a new assembly line in China – this is known as ‘greenfield’ investment. But a lot of foreign direct investment is made by foreigners buying into an existing local company – or ‘brownfield’ investment.[26] Brownfield investment has accounted for over half of total world FDI since the 1990s, although the share is lower for developing countries, for the obvious reason that they have relatively fewer firms that foreigners want to take over.At its height in 2001, it accounted for as much as 80% of total world FDI.[27]
Brownfield investment does not add any new production facilities – when General Motors bought up the Korean car maker Daewoo in the wake of the 1997 financial crisis, it just took over the existing factories and produced the same cars, designed by Koreans, under different names. However, brownfield investment can still lead to an increase in productive capabilities. This is because it can bring with it new management techniques or higher quality engineers. The trouble is that there is no guarantee that this will happen.
In some cases, brownfield FDI is made with an explicit intention of not doing much to improve the productive capabilities of the company bought – a foreign direct investor might buy a company that he thinks is undervalued by the market, especially in times of financial crisis, and run it as it used to be until he finds a suitable buyer.[28] Sometimes the foreign direct investor may even actively destroy the existing productive capabilities of the company bought by engaging in ‘asset stripping’. For example, when the Spanish airline Iberia bought some Latin American airlines in the 1990s, it swapped its own old planes for the new ones owned by the Latin American airlines, eventually driving some of the latter into bankruptcy due to a poor service record and high maintenance costs.
Of course, the value of foreign direct investment to the host economy is not confined to what it does to the enterprise in which the investment has been made. The enterprise concerned hires local workers (who may learn new skills), buys inputs from local producers (who may pick up new technologies in the process) and has some ‘demonstration effects’ on domestic firms (by showing them new management techniques or providing knowledge about overseas markets). These effects, known as ‘spill-over effects’, are real additions to a nation’s long-run productive capabilities and not to be scoffed at.
Unfortunately, the spill-over effects may not happen. In the extreme case, a TNC can set up an ‘enclave’ facility, where all inputs are imported and all that the locals do is to engage in simple assembly, where they do not even pick up new skills.Moreover, even when they occur, spillover effects tend to be relatively insignificant in magnitude.[29] This is why governments have tried to magnify them by imposing performance requirements – regarding, for example, technology transfer, local contents or exports.[30]
A critical but often ignored impact of FDI is that on the (current and future) domestic competitors. An entry by a TNC through FDI can destroy existing national firms that could have ‘grown up’ into successful operations without this premature exposure to competition, or it can pre-empt the emergence of domestic competitors. In such cases, short-run productive capabilities are enhanced, as the TNC subsidiary replacing the (current and future) national firms is usually more productive than the latter. But the level of productive capability that the country can attain in the long run becomes lower as a result.
This is because TNCs do not, as a rule, transfer the most valuable activities outside their home country, as I will discuss in greater detail later. As a result, there will be a definite ceiling on the level of sophistication that a TNC subsidiary can reach in the long run. To go back to the Toyota example in chapter 1, had Japan liberalized FDI in its automobile industry in the 1960s, Toyota definitely wouldn’t be producing the Lexus today – it would have been wiped out or, more likely, have become a valued subsidiary of an American carmaker.
Given this, a developing country may reasonably decide to forego short-term benefits from FDI in order to increase the chance for its domestic firms to engage in higher-level activities in the long run, by banning FDI in certain sectors or regulating it.[31] This is exactly the same logic as that of infant industry protection that I discussed in the earlier chapters – a country gives up the short-run benefits of free trade in order to create higher productive capabilities in the long run. And it is why, historically, most economic success stories have resorted to regulation of FDI, often in a draconian manner, as I shall now show.
‘It will be a happy day for us when not a single good American security is owned abroad and when the United States shall cease to be an exploiting ground for European bankers and money lenders.’ Thus wrote the US Bankers’ Magazine in 1884.[32]
The reader may find it hard to believe that a bankers’ magazine published in America could be so hostile to foreign investors. But this was in fact true to type at the time. The US had a terrible record in its dealings with foreign investors.[33]
In 1832, Andrew Jackson, today a folk hero to American free-marketeers, refused to renew the licence for the quasi-central bank, the second Bank of the USA – the successor to Hamilton’s Bank of the USA (see chapter 2).[34] This was done on the grounds that the foreign ownership share of the bank was too high – 30% (the pre-EU Finns would have heartily approved!). Declaring his decision, Jackson said: ‘should the stock of the bank principally pass into the hands of the subjects of a foreign country, and we should unfortunately become involved in a war with that country, what would be our condition? …Controlling our currency, receiving our public moneys, and holding thousands of our citizens in dependence, it would be far more formidable and dangerous than the naval and military power of the enemy. If we must have a bank … it should be purely American.’[35] If the president of a developing country said something like this today, he would be branded a xenophobic dinosaur and blackballed in the international community.
26
Moreover, brownfield investment can magnify the negative impact of transfer pricing. If a TNC that has bought up, rather than newly created, a company is practising transfer pricing, the firm that has now become a TNC subsidiary could be paying less tax than it used to when it was a domestic firm.
28
Especially when it comes to FDI by collective investment funds (see notes 5 and 22), this may be the sensible strategy, as they do not have the industry-specific knowhow to improve the productive capabilities of the firms they buy up.
29
R. Kozul-Wright & P. Rayment (2007),
30
The measures include: requirements for joint ventures, which increases the chance of technology transfer to the local partner; explicit conditions concerning technology transfer; local contents requirements, which forces the TNC to transfer some technology to the supplier; and export requirements, which force the TNC to use up-to-date technology in order to be competitive in the world market.
31
Sanjaya Lall, the late Oxford economist and one of the leading scholars on TNCs, once put this point welclass="underline" ‘while having more FDI, on the margin, may usually (if not always) bring net benefits to the host country, there still is a question of choosing between different strategies regarding the role of FDI in long-term development’. See S. Lall (1993), Introduction, in S. Lall (ed.),
32
The quote is from
33
Foreign lenders were also badly treated. In 1842, the US became a pariah in the international capital market when 11 state governments defaulted on foreign (mainly British) loans. Later that year, when the US federal government tried to raise a loan in the City of London,
34
The second Bank of USA, set up in 1816 under a 20-year charter, was 20% owned by the government and federal tax revenue was deposited there, but it did not have note issue monopoly, so it could not be considered a proper central bank.